Macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich macro © 2002 Worth Publishers, all rights reserved Topic 12: Stabilization

macroeconomics fifth edition

N. Gregory Mankiw

PowerPoint® Slides by Ron Cronovichm

acro

© 2002 Worth Publishers, all rights reserved

Topic 12:

Stabilization Policy(chapter 14)

CHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policy slide 2

Question 1:Question 1:

Should policy be Should policy be ______ or _____?______ or _____?

Should policy be Should policy be ______ or _____?______ or _____?


Arguments for active policyArguments for active policy

Recessions cause economic hardship for millions of people.

The Employment Act of 1946: “it is the continuing policy and responsibility of the Federal Government to…promote full employment and production.”

The model of aggregate demand and supply (Chapters 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the economy.


Arguments against active policyArguments against active policy

1. ________________ __________: the time between the shock and the policy response takes time to recognize shock takes time to implement policy,

especially fiscal policy__________: the time it takes for policy to affect economy

If conditions change before policy’s impact is felt, then policy may end up destabilizing the economy.


Forecasting the macroeconomyForecasting the macroeconomy

Because policies act with lags, __________

________________________________.

Ways to generate forecasts:•___________________:

data series that fluctuate in advance of the economy

•Macroeconometric ______:Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies


Mistakes Forecasting the Recession of 1982Mistakes Forecasting the Recession of 1982

Year

Unemploymentrate (percent)

1986

Actual

1983:4

1983:2

1982:4

1982:2

1981:4

1981:2

198519841983198219811980

11.0

10.5

10.0

9.5

9.0

8.5

8.0

7.5

7.0

6.5

6.0


Forecasting the macroeconomyForecasting the macroeconomy

Because policies act with lags, policymakers must predict future conditions.

The preceding slides show that The preceding slides show that the forecasts are often wrong. the forecasts are often wrong.

This is one reason why some This is one reason why some economists oppose policy economists oppose policy activism. activism.

The preceding slides show that The preceding slides show that the forecasts are often wrong. the forecasts are often wrong.

This is one reason why some This is one reason why some economists oppose policy economists oppose policy activism. activism.


The Lucas CritiqueThe Lucas Critique

Due to Robert Lucaswon Nobel Prize in 1995 for “rational expectations”

Forecasting the effects of policy changes has often been done using models estimated with historical data.

Lucas pointed out that such predictions would not be valid if the policy change ________

___________________________________

___________________________________.


An example of the Lucas CritiqueAn example of the Lucas Critique

Prediction (based on past experience):an increase in the money growth rate will reduce unemployment

The Lucas Critique points out that increasing the money growth rate may raise expected inflation, _____________________________

___________________________________.


The Jury’s Out…The Jury’s Out…

Looking at recent history does not clearly answer Question 1:

• It’s hard to identify shocks in the data,

• and it’s hard to tell how things would have been different had actual policies not been used.


Question 2:Question 2:

Should policy Should policy be conducted by be conducted by ____ or _______?____ or _______?

Should policy Should policy be conducted by be conducted by ____ or _______?____ or _______?


Rules and Discretion: basic conceptsRules and Discretion: basic concepts

Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through.

Policy conducted by discretion:As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time.


Arguments for RulesArguments for Rules

1. _________________________________

_________________________________ misinformed politicians politicians’ interests sometimes

not the same as the interests of society


Arguments for RulesArguments for Rules

2. The Time Inconsistency of Discretionary Policy def: __________________________

______________________________

______________________________. Destroys policymakers’ credibility,

thereby reducing effectiveness of their policies.


Examples of Time-Inconsistent PoliciesExamples of Time-Inconsistent Policies

To encourage investment, To encourage investment, government announces it government announces it won’t tax income from capital. won’t tax income from capital.

But once the factories are built, But once the factories are built, the govt reneges in order to the govt reneges in order to raise more tax revenue.raise more tax revenue.


Monetary Policy Rules Monetary Policy Rules

c.

a.

b.

d.

Target Federal Funds rate based on inflation rate gap between actual & full-

employment GDP


The Taylor RuleThe Taylor Rule

where:

= nominal federal funds rateffi

GDP Gap = 100Y Y

Y

= the percent by which real GDP

is below its natural rate

+ 2 + 0.5( 2) 0.5(GDP Gap)ffi


The Taylor RuleThe Taylor Rule

If = 2 and output is at its natural rate, then monetary policy targets the nominal Fed Funds rate at 4%.

For each one-point increase in , mon. policy is automatically tightened to ___

_________________________________.

For each one percentage point that GDP falls below its natural rate, mon. policy automatically _________________________________.

+ 2 + 0.5( 2) 0.5(GDP Gap)ffi


Does Greenspan follow the Taylor Rule?Does Greenspan follow the Taylor Rule?

The Federal Funds RateActual and Suggested

0

2

4

6

8

10

12

1987 1990 1993 1996 1999 2002

Per

cen

t

Actual

Taylor's rule


Central Bank IndependenceCentral Bank Independence

A policy rule announced by Central Bank will work only if _____________________

____________________________.

Credibility depends in part on degree of independence of central bank.


Inflation and Central Bank Independence Inflation and Central Bank Independence

Index of central-bank independence

Average in½ation

4.543.532.521.510.5

9

8

7

6

5

4

3

2

Spain

New ZealandItaly

United KingdomDenmarkAustralia

France/Norway/Sweden

JapanCanadaNetherlandsBelgium United States

SwitzerlandGermany

Average inflation

Index of central bank independence


Chapter summaryChapter summary

1. Advocates of active policy believe: frequent shocks lead to unnecessary

fluctuations in output and employment fiscal and monetary policy can stabilize

the economy

2. Advocates of passive policy believe: the long & variable lags associated with

monetary and fiscal policy render them ineffective and possibly destabilizing

inept policy increases volatility in output, employment


Chapter summaryChapter summary

3. Advocates of discretionary policy believe: discretion gives more flexibility to

policymakers in responding to the unexpected

4. Advocates of policy rules believe: the political process cannot be trusted:

politicians make policy mistakes or use policy for their own interests

commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility

Documents

Macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich macro © 2002 Worth Publishers, all rights reserved Topic 12: Stabilization